Business income protection is of utmost importance for any insured suffering a catastrophic property loss. To fully understand business income coverage and the protection the policy extends, four key business income definitions and concepts must be understood:
- Business income;
- Period of restoration;
- Operational capability; and the
- Time doctrine.
Business income (BI) is partially defined in both available coverage forms (CP 00 30 and CP 00 32) as: “Net income… that would have been earned or incurred and [PLUS] continuing normal operating expense incurred, including payroll.” Two key terms in this definition require a more in depth analysis: 1) “net income;” and 2) “continuing normal operating expenses.”
Net Income: Net income as used in the business income form is not defined the same as it is in the world of finance; this is why the business income report/worksheet (CP 15 15) cannot simply be handed to the insured or its accountant without explanation. In the context of business income, “net income” means the entity’s net profit (or loss) before the application of income taxes. In practicality, the BI meaning of net income can be best explained to the accountant as real and potential earnings before taxes (EBT).
How does this definition differ from the financial world’s definition of “net income?” In finance and accounting, net income is understood to mean, “Gross revenue minus all business and production-related expenses.” In finance and accounting, net income only deals with and accounts for money actually earned; in business income, potential income may be contemplated in the coverage – depending on the type of insured.
Notice also that in business income coverage net income includes “net loss.” Why would a business operating at a loss require business income protection? Simple; a business-closing loss would likely create a greater net loss than would have been incurred had no loss occurred.
Continuing Normal Operating Expenses: Continuing normal operating expenses are those normal operating expenditures that continue, in whole or in part, during the time the business operations are shut down or reduced due to a direct property loss (the “Period of Restoration”). These expenses can include mortgage/rent, insurance, payroll (unless altered by an endorsement), and various others. Prior to the loss, the insured is not charged with knowing which expenses will continue, which will be reduced, and which will disappear completely following a loss.
Period of Restoration
Business income’s period of restoration is the time period beginning a specific amount of time following the direct physical loss or damage to the insured structure (usually 72 hours, but the time can be lowered by endorsement) and ending on the earlier of: 1) the date the property should be repaired, rebuilt, or replaced with reasonable speed and similar quality; or 2) the date when operations are resumed at a new permanent location.
During the period of restoration, several objectives must be accomplished to assure the operation can return to operational capability as quickly as possible. Period of restoration’s depth and importance to business income requires greater detail as will be discussed in the coming class.
Operational capability is a non-policy business income term describing the end of the period of restoration. This is the point at which a manufacturing operation can return to pre-loss production and inventory levels (excluding the time necessary to produce the same amount of finished stock on hand prior to the loss); and a non-manufacturing entity can operate with the same level of inventory, equipment, and efficiency as before the operation-closing loss. Operational capability is accomplished either by repairing or rebuilding the current location, or by finding a new permanent location.
To clarify, operational capability is not synonymous with a return to pre-loss income levels, which may take much longer to accomplish. Operational capability is merely the entity’s ability to produce goods and provide service at the same level, efficiency, and speed as before the loss (the ability to conduct operations at pre-loss levels).
A “doctrine” is a principle or body of principles; the time doctrine is the principle around which business income coverage is based. The doctrine is not found in the policy or any other literature detailing business income coverage – it is unique to this author.
Business income exists to insure the continued financial viability of the insured’s business by replacing the net income that would have been earned had no loss occurred and pay any usual and customary expenses that continue during the period of restoration (the period when the insured is non-operational or operating at a reduced capacity) – indemnifying the insured. To that end, the time doctrine is:
All business income losses are settled based on the coverage limit purchased. An accurate business income coverage limit calculation depends on an accurate estimation of the 12-month business income exposure and the legitimate estimation of the worst-case period of restoration. Estimating the worst-case period of restoration necessitates understanding the time required to accomplish each of the 10 steps within the four period of restoration objectives. The key to business income is the correct estimation of time.
Importance of these Terms and Concepts
Business income, period of restoration, operational capability, and the time doctrine are referenced throughout the remainder of this book. All other concepts surrounding business income coverage are built on these four terms and concepts. Knowing and understanding these concepts simplifies and demystifies business income coverage.
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